A Daring but Doomed Proposal

Earlier this month, a value investing conference was held in New York City. One of its purposes was to commemorate the 110th birthday of the father of value investing, Benjamin Graham -- who happens to be, among other things, the mentor of Berkshire Hathaway (NYSE: BRK.A, BRK.B) Chairman Warren Buffett. Many notable investing experts attended and some of them addressed the gathering.

One speaker suggested a radical way to improve the way companies operate. It was Chris Browne of Tweedy, Browne Company, a firm that runs some extremely well-respected mutual funds. Browne made a bold proposal, one he admitted would likely never happen. He suggested that companies be required by law to distribute 100% of their earnings to shareholders -- in the form of hefty dividends. So far, this might sound good to investors, but managers will surely think this daft, as they want to deploy some or all of those earnings in other ways. Well, here's the last part of the proposal: Management would have the power to get some or all of that money back, by making compelling cases to shareholders about how it will be spent.

Imagine, as an example, Amazon.com (Nasdaq: AMZN). In fiscal 2003, its operating cash flow was nearly $400 million, its free cash flow was $346 million, and its net income was $35 million. Imagine that all its available income was distributed to shareholders, and that, not surprisingly, managers had some initiatives they wanted to pursue, some things to do with that money.

Management could send out a ballot to shareholders, detailing how they'd like to spend that money, and shareholders could render a yea or nay for each proposal. Perhaps, for example, management would recommend adding a new major department to Amazon's main storefront -- maybe "Pie Toppings," to join "Books," "Music," etc. Perhaps management also wanted to boost CEO Jeff Bezos' total compensation by 75%. Maybe a new distribution center was deemed necessary, to improve the company's operational efficiency. For each of these items, management could make their case, summing up with the most critical piece of information for shareholders: what kind of return on investment should be expected, and why.

That's a critical question because the allocation of capital (that's money, essentially) is what investing is all about. If a shareholder receives $1,000 from Amazon as a dividend, she has many options. She can spend it, or invest it. If she invests it, she can get up to a few percentage points of return from fairly stable investments such as CDs, money market funds, or bonds. She can also take on more risk and aim for higher returns, perhaps investing in the stock of some promising company. Amazon.com's management will have to persuade her that their plans offer a good risk-reward trade-off in order to get her share of the company's earnings back (in the form of new shares of company stock).

If the management's ideas make sense to most investors, it will get back the money it needs to do what it wants. If not, it won't. This seems pretty reasonable, but it's not how the business world works right now. Management compensation has been skyrocketing fairly unfettered in recent decades. Mergers and acquisitions happen that many soon regret -- such as when Time Warner (NYSE: TWX) hooked up with AOL. This is all because those who really own the companies -- the shareholders -- don't have much power to make investment decisions for the company.

What do you think of this intriguing proposal? Let us know on our discussion board.

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Longtime Fool contributor Selena Maranjian owns shares of Amazon.com, Time Warner, and Berkshire Hathaway.